HIDDEN VALUE IN THE BOND MARKET
Pity the poor premium bond. It is probably the most misunderstood security in the financial marketplace.
The premium bond derives its name from the fact that it sells for a price above 100.00 (par). Depending on the coupon rate, premium bonds can sell for as much as 110, 120 or 130 cents on the dollar. This means that an investor can pay as much as $130,000 for bonds that will mature for $100,000.
Individual investors often have trouble with this concept. They have difficulty comprehending how an investment can be worth while if it returns, at maturity, less money than initially invested.
We feel that if investors would take a moment to look at some fundamental "bond arithmetic" they would recognize that bonds trading above 100.00 frequently provide the highest yields and the best value in the municipal bond market.
WHAT IS A PREMIUM BOND?
Premium bonds did not start that way. It is likely that they were originally issued at par. The key is that they were issued at a time when interest rates were higher. Instead of carrying coupon rates of 5.00% or 5.25%, as are being issued today, these bonds might be paying as much as 7%, 8% or 9%.
If you have been buying bonds over the last five to 10 years, then you have bonds in your portfolio that command a premium price today, even though they may have once traded at par or a discount.
Older bonds are priced to approximate the current interest rate environment, so naturally, an old 8% bond must sell at a higher price than the 5.50%bonds being issued today at 100.
THE CASE FOR PREMIUM BONDS
Premium bonds invariably provide a greater yield to maturity than comparable quality, par or discount bonds. This makes them more defensive (less volatile) when interest rates are rising. Their higher coupon rates generate greater cash flow, which can be reinvested while rates are rising. All bonds fall in value if interest rates rise, but the decline in a premium bond will be less severe. Corporate and treasury bonds selling at a premium also enjoy more price stability because of their higher interest payments. But it is only in the municipal bond market that premium bonds yield substantially more to maturity than other bonds of like maturity and quality. This is because the tax-free bond market is dominated by individual investors, rather than institutions.
the yield to maturity on these bonds to be as much as 50 basis points higher than for a similar discount or par bond.
This yield advantage does not exist with corporate or treasury bonds because professional investors know that yield is the only relevant factor when analyzing a bond investment.
The higher coupons on premium bonds make them more susceptible to being called prior to their maturity date. It is important that you know the dates that the bonds can be called. Your
confirmation should show the "worst case" yield on the bond.
THINK YIELD
Finding the right premium bond will be easy if you use the following rule of thumb: Make sure the yield to the call is higher than it would be if you bought a par bond that was maturing in that year.
For example, a par bond that is due in 2005 would yield approximately 4% in today's market. So if you are buying a premium bond that is callable in 2000, the yield to call should be
approximately 4.50%. The yield to maturity will also be higher than those available on new issues in the same year.
If you follow this rule, you are in a win-win situation. If your bond is called, you receive a higher return than if you bought a bond maturing in that year. If the bond is not called, your yield to maturity will be higher than other bonds issued at the time of your purchase.
This is why purchasing a premium bond with a yield advantage to the call as well as to maturity will always provide the best value in the tax-free bond market.
